Lessons from the Herbalife Showdown

A delightfully entertaining drama is playing out these days. This one features several of Wall Street's heaviest hitters – Carl Icahn, George Soros, Daniel Loeb, and Bill Ackman.

The drama centers on Herbalife (NYSE: HLF), a nutrition company that sells products through a network of individuals who serve as resellers.

It all started when one of the best performing hedge fund managers started publicly bashing the stock. That investment manager is Bill Ackman of Pershing Square Capital.

Pershing Square began shorting-selling Herbalife shares in May 2012. Short-selling is an investment bet that a company’s shares will drop in price. Though Ackman hasn't disclosed his average sale price, Herbalife shares were trading around $45 when he started short-selling the stock.

What we do know is that Pershing Square has amassed a 20-million-share short position. That’s a sizeable position, and equals nearly 19% of Herbalife's outstanding shares. In December, Ackman went public with his position. And he started touring the media circuit, sharing his view that Herbalife was an unsustainable pyramid scheme.

Big-name investors are motivated to tell the world about their deeds. By sharing their positions, their stocks frequently pop. Shortly after Ackman promoted his short position, Herbalife shares dropped to the mid-20s.

But shorting a company and then promoting that short is risky business. The big risk to a short-seller like Akman is the dreaded short squeeze.

Short squeezes can occur in a heavily shorted stock. If there is increased buying of the stock, the share price rises. But with a large number of shares tied up by short sellers, the price can rise very quickly.

The first hedge fund manager to bet against Akman was Daniel Loeb.

Loeb's analysis painted a different picture of Herbalife – one of a viable business with growth potential. Loeb started buying up the stock, and then publicly shared his views.

Carl Icahn followed suit a couple months later, promoting his own pro-Herbalife outlook. And most recently, George Soros acknowledged his long position in Herbalife. Once Loeb and Icahn went public, Herbalife shares whipped back, and have since pushed forward to the mid-60s.

Herbalife's price is being sent higher, thanks to short sellers who are covering their positions. Additionally, new long investors who are following Loeb, Icahn, and Soros are buying the stock.

And Bill Ackman is paying the price. His Herbalife bet has resulted in a $400 million loss. Ackman says that hasn’t covered his short position.

So what should investors do when a Herbalife situation arises? There's an opportunity, but the reward of the opportunity must be balanced against the risk.

I'll concede that I avoid short-selling for the reasons discussed today. Yes, it was possible to make a quick profit by shorting after Ackman shared his position. But that opportunity was short lived.

Investing for the long-term is also not a sure thing. Had Loeb and Icahn not stepped forward with their support, Herbalife shares would likely be trading considerably lower than they are today.

What should you do if you own an investment that comes under the glare of the public spotlight? My best advice is to hold firm and reevaluate your investment thesis. Don't assume the big-name investors understand the situation any better than you.

I speak from experience. Two High Yield Wealth recommendations were targets of short sellers. These sellers shorted the stocks and then talked up their positions on the media.

My response was simply to review my analysis, which remained valid. I neither sold nor bought. I simply stood pat. And shares of both companies have since recovered.

I never blindly follow the actions of a famous investor, because I never know of his next move (which will be made long before you find out). Daniel Loeb treated Herbalife as a trade, and quickly closed his position. Icahn and Soros appear to have longer-term commitments, but you can't be sure.

When a drama like Herbalife comes along, I prefer to remain on the sidelines and enjoy it from afar. But if I find myself part of the drama, my analysis for being there directs my actions.

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